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Passive Loss Rules (Portfolio 549)

Tax Management Portfolio, Passive Loss Rules, No. 549-2nd, describes in detail the application of the passive loss rules to losses and credits from investments in passive activities. In general, the passive loss rules limit the deduction of net losses from passive activities and the use of credits from such activities to offset tax liability on income that is not from such activities. These rules, which apply generally to all non-corporate taxpayers (and personal service corporations and closely held C corporations), treat portfolio income (e.g., dividends and interest not derived in the ordinary course of business) as income not derived from a passive activity.

DESCRIPTION

Tax Management Portfolio, Passive Loss Rules,
No. 549-2nd, describes in detail the application of the passive loss
rules to losses and credits from investments in passive activities. In
general, the passive loss rules limit the deduction of net losses from
passive activities and the use of credits from such activities to offset
tax liability on income that is not from such activities. These rules,
which apply generally to all non-corporate taxpayers (and personal
service corporations and closely held C corporations), treat portfolio
income (e.g., dividends and interest not derived in the ordinary course
of business) as income not derived from a passive activity.

In general, passive activities under the rules are those
activities involving the conduct of a trade or business in which the
taxpayer does not materially participate. Material participation
requires regular, continuous, and substantial involvement by the
taxpayer in the operations of the activity — a relatively high standard
that requires considerably more than general management responsibility.
All rental activities are treated as per se passive, except for
interests in rental real estate owned by certain real estate operators.
Except as provided in regulations, no interest as a limited partner is
treated as an interest with respect to which the taxpayer materially
participates.

Deductions and credits from passive activities that are
disallowed for any year, because in excess of income and tax liability
attributable to all such activities, are suspended and carried forward
indefinitely to be used against passive income arising in a subsequent
taxable year. Suspended passive losses are allowed against nonpassive
income upon the disposition of the taxpayer's entire interest in the
activity, or in limited cases upon a partial disposition. Certain losses
and credits from rental real estate activities may also be allowed
against nonpassive income and tax liability, up to a maximum of $25,000
per year.

AUTHORS

DANIEL N. SHAVIRO

Daniel N. Shaviro, A.B., Princeton University (1978); J.D., Yale Law School (1981); member, District of Columbia Bar; author of various books including When Rules Change: A Political and Economic Analysis of Retroactivity and Transition Relief and Making Sense of Social Security Reform; contributor of articles to various journals including Tax Law Review, Virginia Tax Review, TAXES, Harvard Law Review, University of Chicago Law Review, and Michigan Law Review; Caplin & Drysdale, Washington D.C. (1981–84); Legislation Attorney, Joint Committee on Taxation (1984–87); Assistant Professor and then Professor of Law at University of Chicago Law School (1987-1995); Professor of Law at NYU Law School since 1995.

TABLE OF CONTENTS

Detailed Analysis

I. Overview

II. Taxpayers Subject to the Passive Loss Rules

A. In General

B. Personal Service Corporations

1. Definition

2. Definition of an Employee–Owner

3. 10% Ownership Requirement

4. Meaning of “Personal Services”

5. Meaning of “Substantially Performed by Employee–Owners”

C. Closely Held C Corporations

1. Definition of “Closely Held”

2. Application of the Passive Loss Rules to Closely Held C Corporations

D. Consequences of Ceasing to Be a Corporation Subject to the Passive Loss Rules

E. Treatment of Consolidated Groups

1. In General

2. Intercompany Transactions Between Members of a Consolidated Group

F. Treatment of Publicly Traded Partnerships

1. Background–Related Statutory Provision

2. Tax Treatment of Partners in a PTP That Is a Partnership for Tax Purposes

a. Modified Application of the Passive Loss Rules

b. Tax Treatment of Corporate Partners in a PTP That Is a Partnership for Tax Purposes

III. Identifying Passive Activities

Introductory Material

A. Definition of a Separate Activity

1. Significance of Identifying Separate Activities

2. A Brief History of the Activity Regulations

3. The Permanent Activity Regulations

a. Overview

b. Allowance of Any Reasonable Method in Grouping Activities

(1) Scaled-Down Implicit Retention of the “Building Block” Approach

(2) Taxpayer Discretion in Applying Relevant Facts and Circumstances

c. Decisions to Be Made at the Entity Level by Partnerships and S Corporations

d. Limitations on Grouping Certain Types of Activities with Other Types of Activities

(1) Overview

(2) General Limitation on Grouping a Rental Activity with a Trade or Business Activity

(3) Exception for Trade or Business Activity and Rental Activity with Same Proportionate Ownership

(4) Limitation on Grouping Rentals of Real Property with Rentals of Personal Property

(5) Limitations in Grouping Certain Activities of Limited Partners and Persons Not Sufficiently Involved in Management

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